Profitability is one of the main factors to look at when analyzing a company. It’s not only the reason for a company’s existence, but also a key element when determining whether to invest in a company or not. Thus, in this article I will look into 3M Co. (NYSE:MMM)’s earnings, profit margins, profitability ratios and cash flow, in addition to evaluating which institutional investors bought the stock in the recent quarters.

A part of the S&P 500 list, and with a wide economic moat, this industrial product manufacturer’s track record of innovation, low-cost productions and scale advantages have made it one of the most successful industry players in the world. With a management team focused on research and development spending, the company’s recent shift towards the biometrics and health care segment have been rather profitable. In fact, following 2012’s acquisition of ceramics manufacturer Ceradyne Inc. (CRDN), the firm is now looking to purchase the health-care data analytics company Treo Solutions, in order to boost overall growth rates.

This company’s growth has been particularly propelled by its diverse product portfolio, which ranges between several disparate end markets, and includes popular names like Scotch tape and Post-it Notes. By acquiring new pillars or leveraging technology across multiple industries, the firm has been able to sustain solid levels of 6% growth, with an upward trend.

Earnings Growth

If you go back through the history of the stock market, there is a recurring theme among those stocks which have had some of the strongest price appreciation, and it's related to their earnings growth. If you plot a chart of earnings growth versus a company's stock price there is a usually a strong relationship between the two. So, the first step when analyzing 3M Co. is evaluating its earnings potential.

Last quarter, the firm retrieved an EPS growth rate of 6.6% compared to the same quarter in the previous year. Some investors are bullish on the idea that the company will improve its quarterly EPS growth in the near future. Furthermore, sell-side analysts just upgraded EPS projections for the company, increasing EPS estimates by 11.0% for the current year. In addition, 3M Co. generated three-year average annual EPS growth of 11.82%. In my view, this growth rate is rather slow compared to the three-year annual growth levels of minimum 15% that I’m looking for.

Revenue Growth

The company reported a 2% quarterly revenue growth year over year, well below my minimum requirement of 15% quarterly year-over-year growth when investing in growth stocks. While this does not necessarily prevent me from investing, I’ve found that the best opportunities come from companies that retrieve outstanding quarterly sales growth rates.

I also looked at how 3M Co. increased its earnings over the past three years and in this company’s case found annual sales growth of 5.01%. This is a very important metric that Investors Business Daily (IBD) — the best source for growth stocks ideas — pays attention to when analyzing high growth companies, and so should you. I do not like the fact that this firm’s growth is below the 15% mark because the best growth companies generate more than that level before their stock makes huge price advances.

Gross Profit Margin

The gross profit margin measures a company's manufacturing and distribution efficiency during the production process, apart from telling an investor the percentage of revenue/sales left after subtracting the cost of the goods/services sold. A company that operates on a higher profit margin than its competitors is more efficient, making it more attractive to investors.

In the case of 3M Co., its gross margins increased over the past years. The five-year low for the gross margin was reported at 47.0%, while the current margin of 48.1% is the five-year high point. Moreover, the TTM gross profit margin of 47.8% is above the five-year average of 47.6%. A gross margin above the five-year average implies that management has been successful in making the manufacturing and distribution during the production process more efficient over the five-year period.

Operating Margin = Operating Income / Total Sales

The operating margin measures the proportion of a company's revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales. Needless to say: the higher the margin, the better.

Over the past five years, the operating margin of 3M Co. has been increasing. While in 2009 the company reported an operating margin of 20.8%, this metric has grown over the past 12 months, reaching 21.6%. As this ratio is above the five-year average of 21.4%, it implies that there has been an increase in the percentage of the total sales left over after paying for variable costs of production.

Net Profit Margin = Net Income / Total Sales

This ratio measures how much out of every dollar of sales a company actually keeps in earnings. The profit margin is a very useful metric when comparing companies in the same — or similar — industries. A higher profit margin indicates a profitable company with strong control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Over the past five years, 3M Co.'s net profit margin has been increasing in comparison to the five year average margin. The TTM net profit margin of 15.09% is above the five-year average of 14.6%, implying that the company is gaining strength. I require strong net profit margins when investing in a stock for the long term.

ROA - Return on Assets = Net Income / Total Assets

The ROA metric is important because it gives us an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage and is sometimes referred to as "returns on investment."

3M Co.’s 2012 ROA of 13.82% is slightly above the five-year average of 13.52%, implying that management has improved its ability to use the company's assets to generate earnings over the past five years.

Free Cash Flow = Operating Cash Flow - Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures, free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

3M Co. generated a ratio of cash flow from operations/total sales of 13.45. The higher this percentage is, the more cash is available from sales.

Institutional Investors

I also evaluate recent institutional activity in the stock. In other words, which hedge funds bought the stock over the past few months. I feel encouraged by the fact that Jim Simons (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio) bought the stock in the past months at an average price of $128.29, because it shows that hedge funds have confidence in the stock.

Analyst Outlook

Currently, many analysts have a good outlook for 3M Co. Analysts at MSN Money are predicting that 3M Co. will retrieve EPS of $6.70 for fiscal year 2013 and an EPS of $7.38 for fiscal year 2014. Analysts at Bloomberg estimate 3M Co.'s revenue to reach $30.93 billion for fiscal year 2013 and $32.58 billion for fiscal year 2014.

Bottom Line

While 3M Co.’s balance sheet is somewhat irregular, showing sluggish growth regarding revenue and EPS growth, efficiency has become more central in management’s strategy, which is noticeable through improvement in gross margins, operating margins and net margins, as well as ROA results.

Furthermore, I remain confident in this company’s wide economic moat and competitive advantage, which will continue to push growth and outrun market rivals like Danaher Corporation (NYSE:DHR) in the future. Also, with the stock currently trading at a fair 19.70x trailing earnings relative to the industry average of 20.50x, I think investors looking for profitability may have a lot to gain when it comes to this industrial manufacturer.

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